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Chapter 7 The Firm. Business Firm. Employs factors of production Produces goods and services Sells to consumers, other firms, or the government We work for and buy from firms. Market. Two sides Buyers Utility is major decision making device Sellers How do they make decisions.

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business firm
Business Firm
  • Employs factors of production
  • Produces goods and services
  • Sells to consumers, other firms, or the government
  • We work for and buy from firms
  • Two sides
    • Buyers
      • Utility is major decision making device
    • Sellers
      • How do they make decisions
how do the two sides come together
How do the two sides come together?
  • Market Coordination
    • Invisible Hand (Adam Smith)
    • Market guides individuals into activities at which they are the most efficient
    • Pushes sellers to produce certain things and buyers to instruct what to produce
    • Equates supply and demand
how does the firm decide what to produce
How does the firm decide what to produce?
  • Managerial Coordination
    • Guides individual firm production decisions
    • Thus…invisible hand of the firm
why follow this invisible hand
Why follow this invisible hand?
  • Firms are formed because greater benefits of working as a team than working as individuals
problem with teamwork
Problem with teamwork
  • Shirking
    • Putting forth less effort than your originally agreed to
    • Problem because shirker gains ALL benefits from shirking but costs are spread over the entire team
can shirking increase or decrease
Can shirking increase or decrease?
  • Yes!!
  • As the benefits of shirking increase so does the amount
  • If the shirker must bear the full cost of shirking then shirking will decrease
how can we decrease shirking
How can we decrease shirking?
  • Manager’s duty or MONITORING
  • Reward productive workers and punish shirkers
  • Preserves the benefit of team production
  • Reduces the benefits of shirking
who monitors the monitor
Who monitors the monitor?
  • Salary usually tied into production
  • Called Residual Claimant
    • Person who shares in the profits of the firm
    • More shirkers?? Less Production…so less pay for monitor
another way to ward off shirking
Another way to ward off shirking?
  • Pay higher than equilibrium wages
  • Decreases shirking because cost of losing job is greater.
  • Don’t need monitor because high wage makes worker monitor themselves
  • Called efficiency wage theory
why do people submit to being monitored
Why do people submit to being monitored??
  • Monitoring decreases shirking
  • Monitoring increases benefits of teamwork
  • Monitoring maximizes benefits that can be achieved
objective of the firm
Objective of the firm
  • Profit Maximization
  • Now…want to move to the Firm to see how they achieve this objective
chapter 8 production and costs
Chapter 8Production and Costs

© South-Western College Publishing 1998

cost side
Cost Side
  • Explicit Cost
    • Actual money is exchanged
    • COST
  • Implicit Cost
    • Value of resources used in the production or acquisition of a good
    • No monetary payment
  • In order to have a cost, sacrifice must have taken place
  • Forfeited something else
  • No money must change hands for sacrifice to take place
  • Two types
    • Accounting
      • Difference between total revenue and explicit costs
      • Acct Profit = TR – EXPLICIT COSTS
    • Economic
      • Difference between total revenue and total cost (implicit and explicit)
      • Econ Profit = TR – Explicit Cost – Implicit Cost
which do you think is lower
Which do you think is lower??
  • Economic Profit
  • Usually lower but never higher
  • How can it be “usually” lower?
  • Implicit cost can equal 0 so accounting and economic profit would be equal
zero economic profit
Zero Economic Profit
  • Total Revenue-explicit cost-implicit costs = 0
  • Also called NORMAL PROFIT
  • Equilibrium of profit for the firm
  • Would we want zero accounting profit?
  • NO!!! Implicit costs would not be covered
sunk versus fixed costs
Sunk versus Fixed Costs
  • Sunk
    • Incurred in the past
    • Cannot be changed by a current decision
    • Cannot be recovered
    • Example: Time spent in school
    • Can’t recover so let it go…Release it
  • Fixed
    • Possibility of recovering some money for selling the good
    • Example: Land, equipment…
  • Takes time to produce
  • Costly to produce
  • Direct link between production, costs, and time
two types of time
Two types of time
  • Short Run
    • Fixed and variable inputs
  • Long Run
    • All inputs are variable
short run
Short Run
  • Fixed input
    • Quantity can not be changed
    • Independent of output produced
    • Example: Building, land…
  • Variable input
    • Quantity can be changed as output changes
    • Example: Labor
  • Fixed Cost (FC)
    • Associated with fixed inputs
    • Do not change with output
    • Example: Insurance premiums
  • Variable Costs (VC)
    • Associated with variable inputs
    • Changes as output changes
    • Example: Hire more people and must pay more wages
total costs
Total Costs
  • Variable Cost + Fixed Cost
other costs of importance
Other costs of importance…
  • Average Variable Cost (AVC)
  • Average Fixed Cost (AFC)
  • Average Total Cost (ATC)
marginal cost
Marginal Cost
  • Change in TC that results from a change in output
  • Additional cost of producing an additional unit of output
why change in total cost or total variable cost
Why Change in Total Cost or Total Variable Cost????
  • Since total fixed cost doesn’t change the “additional” total fixed cost is zero
shapes of curves
Shapes of Curves
  • Law of diminishing marginal returns
    • As larger amounts of a variable input are combined with fixed inputs eventually the Marginal Physical Product (MPP) declines
marginal physical product mpp
Marginal Physical Product (MPP)
  • What is the variable input?
  • What is the variable cost?
  • As more labor (VARIABLE INPUT) are added to land (FIXED INPUT) the variable inputs would yield smaller and smaller additions to output
crowding problem
Crowding Problem
  • The point at which MPP declines
  • Shows the law of diminishing returns
average physical productivity
Average Physical Productivity
  • Output divided by Inputs (usually labor)
  • Good for comparing firms or countries.
so find that
So find that…
  • MC and MPP are related
  • What is the relationship?
does this relationship make sense
Does this relationship make sense?
  • Yes..
  • If productivity increases what would happen to costs??
    • Decrease (MPP increase & MC decrease)
  • Productivity decreases??
    • Increase (MPP decreases & MC increases)
mpp determines shape of mc
MPP determines shape of MC
  • MPP must have a declining part because of diminishing returns
  • Can also define MC as:
in class exercise 11

In-class exercise 11

How do we calculate these costs??

Give two ways to get to the cost…

average marginal rule
Average-Marginal Rule
  • Can use to see what the ATC and AVC curve look like
  • Tells us what happens when MC is above or below the “average” curves
  • If MC is above AVC and ATC
    • AVC and ATC are rising
  • If MC is below AVC and ATC
    • AVC and ATC are falling
from average marginal rule can infer
From Average-Marginal Rule can infer…
  • MC intersects the AVC and ATC curves at their MINIMUM POINTS
  • Cannot infer anything about AFC
  • MC gains it shape from???
    • MPP and law of diminishing marginal returns
  • MC below ATC: What is ATC curve doing?
    • Falling
  • MC above ATC: What is ATC curve doing?
    • Rising
tying products to costs

Tying Products to Costs



Variable Input

When MC is below



Production in the

short run: at

least one fixed input

When MC is above



Variable Input


now switching to the long run
Now switching to the Long Run
  • When does Long Run start?
    • As soon as all inputs (costs) are VARIABLE
    • No fixed costs
  • Important curves
    • LRTC
    • LRATC
    • LRMC
short run vs long run
Short Run vs. Long Run
  • Short Run assumes FIXED plant size
  • Each plant size has a unique ATC curve associated with it
    • SRATC
  • LRATC combines all the SRATC curves
  • Which points of the SRATC???
  • Minimum points
why minimum
Why minimum?
  • LRATC shows the lowest average cost at which a firm can produce any given level of output
  • LRATC is the lower ENVELOPE of the SRATC curves
  • Called envelope curve
isn t the lratc curve smooth
Isn’t the LRATC curve smooth??
  • Yes!!
  • Have infinitely many SRATC curves so it would be smooth if use all curves
  • Each SRATC curve touches the LRATC curve only once
shape of lratc
Shape of LRATC
  • U-shaped
  • Decreasing, Flat, then Increasing
  • Important when finding optimal long run output level
economies of scale
Economies of Scale
  • Downward part of LRATC
  • Average costs decrease as output increases
  • If have a 1% increase in input usage what happens to output??
    • Increases by MORE than 1%
  • Specialization
constant returns to scale
Constant Returns to Scale
  • Flat portion of LRATC
  • Costs remain the same as increase output
  • If have a 1% increase in input usage what happens to output??
    • Output increases by EXACTLY 1%
  • First point of constant returns to scale is called MINIMUM EFFICIENT SCALE
diseconomies of scale
Diseconomies of Scale
  • Upward sloped portion of LRATC
  • Costs are rising as we increase output
  • If have a 1% increase in input usage what happens to output?
    • Increases by LESS THAN 1%
  • Why???
    • Firm too large (bad communication or coordination problems)
are economies diseconomies and constant returns to scale in sr lr or both
Are economies, diseconomies, and constant returns to scale in SR, LR, or both???
  • Why?
    • Inputs necessary for production are able to be changed
    • No fixed inputs
is this the same as diminishing returns
Is this the same as diminishing returns?
  • NO
  • Diminishing returns is from using ONE plant size intensely
    • Short run
  • Economies of scale is from CHANGING plant size
    • Long run
  • Economies of Scale
    • LRATC falling
  • Constant Returns to Scale
    • LRATC flat
  • Diseconomies of Scale
    • LRATC rising
why does economies of scale exist
Why does economies of scale exist?
  • Large firms offer more opportunity for workers to specialize
  • Growing firms can take advantage of efficient mass production techniques
    • Smooth cost over more units produced
why does diseconomies of scale exist
Why does diseconomies of scale exist?
  • Communication problems
  • Shirking
  • Management problems
why is minimum efficient scale important
Why is minimum efficient scale important?
  • Lowest output level at which ATC are minimized
  • Which has a cost advantage??
    • Small firm at minimum efficient scale point
    • Larger firm producing more output but still within constant returns to scale area
    • Neither
where would you expect to find less firms using mes
Where would you expect to find less firms? (using MES)
  • Firms with higher MES
  • Why??
    • Produce until MES
    • If MES is higher then each firm will be producing more…so need less firms to cover quantity wanted by economy
  • Many SHOE companies (MES = .2)
  • Few REFRIGERATOR companies (MES = 14)
efficient number of firms
Efficient Number of Firms
  • 100 divided by MES
  • 100% of goods are wanted by consumers
  • MES is the percentage of consumption each firm will provide
  • Cigarette firm’s MES = 6.6
    • Need 15 firms
  • Petroleum firm’s MES = 1.9
    • Need 52 firms
  • Thus a larger MES means less firms needed
what cause srtc lrtc and mc to shift
What cause SRTC, LRTC, and MC to shift?
  • Taxes
    • Does it affect FC??
      • Only if it is a lump sum tax (tax for existing)
      • If it is a per unit tax then FC doesn’t change
    • How does it change curves??
  • Input prices
    • How does it change curves??
  • Technology
    • Either improves production process (use less inputs) or lower input prices
    • How does it change curves??
homework due monday may 19th
Homework due Monday May 19th
  • Chapter 8
    • Questions: 3, 5, 10, and 11
  • Working with numbers and graphs
    • Questions 3, 6, and 7
in class exercise 12

In-class exercise 12

Do we understand Chapter 8??

chapter 10

Chapter 10


  • One seller
    • Firm is the industry
  • No substitutes for good
  • Many barriers to entry
government can grant monopoly power in three ways
Government can “grant” monopoly power in three ways…
  • Public franchise
    • Exclusive provider
      • Power companies, water companies
  • Patents
    • Exclusive provider for 17 years
    • Encourages people to invent new things
      • Zantac, Tagament
  • Licenses
    • Must have to operate
      • Cabs in New York City
monopolies exist because
Monopolies exist because:
  • Legal mandate
    • Government allows or doesn’t allow you to operate
  • Economic rational
    • Natural Monopolies
      • One firm can produce more efficiently than many
    • Exclusive ownership of resource to make the good
two types of monopolies
Two types of Monopolies
  • Government monopolies
    • Legally protected from competition
  • Market monopolies
    • Protected from competition due to economies of scale
price maker
Price maker
  • Firm is the market
  • Firm has some control over the price it sets
  • Law of Demand still hold
    • Price increases leads to less quantity demanded
demand curve
Demand Curve
  • Remember the individual firm is the market
  • What does the demand curve look like??
    • Downward sloped
    • Want to sell more must lower the price
what differs here from perfect competition
What differs here from Perfect Competition??
  • Price doesn’t equal MR!!!
    • Price > MR
  • Monopolist’s demand curve and marginal revenue curves are DIFFERENT
  • After the first point Marginal Revenue falls twice as fast as Demand
  • Profit Maximization
  • What is the profit maximization rule?
    • MR = MC
  • Want to charge the highest price per unit of quantity sold
three cases
Three cases
  • P > ATC
  • P < ATC
  • P=ATC
  • Where is AVC??
    • Since monopoly is the industry no need to segment total cost
    • If suffer a loss can just increase prices to cover the loss
differences between monopoly and perfect competition
Differences between monopoly and perfect competition
  • P = MR for perfect competition but P > MR for monopoly
  • P = MC for perfect competition but P > MC for monopoly
  • Monopolist can change prices
  • Both try to maximize profits
  • Both are constrained by their demand curves
  • Both equate MR and MC
long run profits
Long Run Profits
  • Perfect Competition
    • Zero Economic Profit (normal profit)
  • Monopoly
    • No entry
    • Profits can be reduced in two ways
      • Capitalization of profits
      • Monopoly rent seeking
capitalization of profits
Capitalization of Profits
  • Firm owner eventually may sell the business
  • When sell…include profits into the price
    • Include in TFC
  • New owner will face a higher ATC than previous owner
    • Includes old owner’s profits
  • Increase in ATC eliminates profit for new owner
economic rent
Economic Rent
  • Profits that can’t be reduced by new entrants
  • Payment in excess of opportunity cost (profit)
  • May bring about Rent Seekers
    • Try to find markets that can gain monopoly status
    • Time and resources expended to try to get monopoly reduces economic rent
monopolies are inefficient compared to perfect competition
Monopolies are inefficient compared to Perfect Competition
  • Welfare cost of monopoly
    • Lower levels of output produced with monopoly than perfect competition
    • Perfect competition produce where P=MC
    • Monopoly produce where MR=MC and P > MC
    • Welfare cost is about 1% of total output
  • Rent seeking is socially wasteful
    • Use resources not in production but to gain monopoly power
x inefficiency
  • Monopoly has no competition
  • No incentive to operate at lowest cost
does monopolist have to charge same price to everyone
Does monopolist have to charge same price to everyone?
  • No!!
  • Called Price Discrimination
  • Three types
    • First degree (perfect price discrimination)
    • Second degree (bulk pricing)
    • Third degree (group pricing)
perfect price discrimination
Perfect Price discrimination
  • Highest price willing and able to pay is charged to each person
  • Price determined by placement on demand curve
  • Discrimination among units
    • Ex. Schools
bulk pricing
Bulk Pricing
  • Different prices for different quantities sold
  • Discrimination among quantities
  • Ex. costco
group pricing
Group Pricing
  • Different prices for different segments of the market
  • Ex. Senior citizen discounts, coupons, different seats in movie or plane…
why price discriminate
Why Price Discriminate?
  • To gain some of the consumer surplus lost when charge everyone the same price
  • If successfully perfectly price discriminate
    • P=MR for all units sold
    • MR and TR increase
    • Eliminate consumer surplus
why doesn t everyone price discriminate
Why doesn’t everyone price discriminate?
  • Seller must be a price maker
  • Seller must know each consumer’s willingness to pay
  • Must be impossible for consumers to resell to others
    • Arbitrage
    • Buy for a low price and sell at a higher price
does a monopolist exhibit resource allocative efficiency
Does a monopolist exhibit resource allocative efficiency?
  • Perfect competition does!!
    • P = MC
  • Monopolist doesn’t!!
    • P > MC
  • Perfectly Price Discriminating Monopolist does!!
    • P = MC
so does one person paying high prices mean that another can pay low prices
So does one person paying high prices mean that another can pay low prices??
  • No!!
  • Perfect Price Discrimination means that each person pays the highest price they are willing and able to pay
would firms rather be a monopoly
Would firms rather be a monopoly?
  • Yes!!
  • Rent seekers try to “buy” monopoly positions.
  • Why?
    • Fewer constraints on production behavior
    • Ability to charge different prices to different segments of the population